Taking Moody’s to Task

Moody’s (MCO) is one of the key enablers in the housing crisis and the sub-prime debacle. Considering the massive damage they are at least partially responsible for, they have escpaed been relatively unscathed — so far. Their reputation is in tatters, and their stock price is down, but given the culpability, payola, and gross incompetence, one might have thought an Arthur Anderson-like demise was a possibility.

I had forgotten that Warren Buffett was Moody’s biggest shareholder; he should consider himself lucky that Moody’s situation hasn’t tarnished his reputation, either.

The WSJ calls Moody’s out on their role as objective arbiter of ratings:

"Bond-rating agency Moody’s Investors Service used to be an ivory tower of finance. Analysts were discouraged from having a drink with a client. Phone calls from bankers went unanswered if they rang during intense, almost academic debates about credit ratings.

A decade ago, as the housing market was just beginning to take off, Moody’s was a small player in analyzing complex securities based on home mortgages. Then, Moody’s joined Wall Street and many investors in partaking of the punch bowl.

A firm once known for a bookish culture began to focus on the market share that affected its own revenue and profit. The rating firm became willing, on occasion, to switch analysts if clients complained. An executive overseeing mortgage ratings went skydiving with a client. By the height of the mortgage-securities frenzy in 2006, Moody’s had pulled even with its largest competitor, rating nine out of every 10 dollars raised in these instruments. It gave many of the bonds its coveted triple-A rating.

Profits at the 99-year-old firm, which John Moody started to rate railroad bonds, rose 375% in six years. The share price quintupled.

Now, Moody’s and the other two major rating firms, the Standard & Poor’s unit of McGraw-Hill Cos. and the Fitch Ratings unit of Fimalac SA, are under fire for putting top ratings on securities that ultimately collapsed in value. Investors, many of whom relied on ratings to signal which securities were safe to buy, have lost more than $100 billion in market value. The credibility of the ratings system is in tatters as new downgrades of mortgage securities come almost weekly. Investigators from Congress, the Securities and Exchange Commission and several state attorneys general are examining the rating firms’ practices."

Instead of competition forcing the firm to be cautious in the face of other’s recklessness, it actually levered them up further in order for them to stay competitive.

The genius of financial engineering and unfettered capitalism in its fullest flower . . .

>

Source:
RATING GAME: As Housing Boomed, Moody’s Opened Up
AARON LUCCHETTI
WSJ April 11, 2008; Page A1
http://online.wsj.com/article/SB120787287341306591.html

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  1. Philippe commented on Apr 11

    It may be worth giving consideration to the idea of merging whole or parts of The IMF and the World Bank in order to set up healthy competition in the shrinking oligopoly world of the rating agencies.
    The benefit are multiple, source of incomes for agencies which are most costs than profits to the members, a healthy and impartial competitor in the field of rating.
    The geographical representation of the IMF and WB are very often binomial and the top down and bottom up analysis could be more effective.

  2. Rubens commented on Apr 11

    Excuse me but the conviction of Arthur Andersen was huge mistake and overreaction by the Justice system. First of all, they were convicted of obstruction of justice because of the shredding of Enron documents, not because of their role in accounting fraud. Second, their conviction was overturned by the Supreme Court in 2005, too late to revive the company, which had been barred from auditing public companies since 2002. Third, it is widely recognized that the actions of a dozen people in the Houston office did not justify bringing down a company of 85,000 worldwide. People should have been indicted, not the whole firm.
    I am pretty sure Moody’s will survive well and won’t be convicted of any crime related to the subprime mess. The government (regulators, etc.) should be doing more to bring real competition to the rating agency duopoly.

  3. Greg0658 commented on Apr 11

    Rubens ?
    do you know in general where the 85,000 people went?
    1>scattered to the competitors
    2>rebranded themselves

  4. VennData commented on Apr 11

    Ratings? What good are they? Fiduciaries need to have internal financial analysts. Ratings are simply CYA BS.

    Arthur Anderson had a history of aggressive actions created by the slowly changing legal framework for which they lobbied and abetted. From Newt Gingrich’s “Contract on American” which wanted to limit liability lawsuit to the ‘Private Securities Litigation Reform Act of 1995’ which Bill Clinton unsuccessfully vetoed (and was passed by the GOP Congress) the accounting profession were given a free ride to work with management as opposed to being independent.

    Yeah Oliver North got off in the end too, but Anderson was made an example, Bear Sterns-like, that our system can’t operate that way.

  5. Dee Leverage commented on Apr 11

    Where is everybody??? G.E. just warned big time. Luckily they have a built in PR outlet that will have no problem spinning it positively. I guess I’ll wait for Barry to post something about this before starting a discussion. Looking at a G.E. chart, my target is 30% more downside to lower 20s. (I must control manaical laughter…my friends at CNBC finally get what they deserve)

  6. wally commented on Apr 11

    On this on I must disagree with you. Any investor is responsible for his or her own due diligence. You cannot farm out the risk calculation for a fee. If Moody’s is to be held responsible, then they should have been given an equity holder position in things they rated, not given a fee.
    To say Moody’s was an enabler is a ducking of responsibility.

  7. Dee Leverage commented on Apr 11

    This is actaully a good test case to see if CNBC has had a large influence on investors, because today, their cheerleading is defrocked. The bigger the crash today, the bigger influence they have.

  8. Murray Trillionaire commented on Apr 11

    I think that everything should be put in the hands of the same people that guard the secrecy of the winner at This Miss Universe Pageant. Look at the amount of pressure they are under to make sure info is not leaked. And they NEVER fail.

  9. tonyskriba commented on Apr 11

    Barry:

    Excellent post, as always. I’m curious if you could speak to other determinants of the rampant grade inflation witnessed among the CRAs; I’m thinking of institutional or federal requirements for certain investors to hold only AAA rated paper. How prevalent are / were these?

    As you’ve pointed out in previous posts, the efficient market hypothesis has been sorely put to the test. Does an alternative regime exist for transmitting signals about an investment’s quality, or are CRAs the only game in town? Is more oversight required; more importantly, would it work?

    Regardless, keep up the good work.

  10. Marcus Aurelius commented on Apr 11

    Dee Leverage:

    Please post the url to your blog.

  11. Ross commented on Apr 11

    RE: Moody’s… Drunk with averice and power.

    See today’s ‘Wizard of Id’ for the solution.

    RE: G.E. So who is supprised?

  12. Ross commented on Apr 11

    RE: G.E.

    Isn’t G.E. part of the shadow banking system?

    Every treasury department of every major corporation is run like a hedge fund.

  13. Philippe commented on Apr 11

    « Ratings? What good are they? Fiduciaries need to have internal financial analysts. Ratings are simply CYA BS. »

    « On this on I must disagree with you. Any investor is responsible for his or her own due diligence. You cannot farm out the risk calculation for a fee. If Moody’s is to be held responsible, then they should have been given an equity holder position in things they rated, not given a fee. »

    These comments are valid but distort the reality, most of the investment papers and stocks as sold by banks are always carrying a label « rating by.. », most of the assets that financial companies are holding bear the same labels « rating by.. »
    Prudential ratios as required by central banks are referring to assets classes and their ratings, BIS ratios on liquidity are requiring the same.
    At this juncture you may introduce your own financial analyst and rate the assets as AAA or its equivalent marked to believe or level 3 or obtain a benchmark from markets or rating agencies
    In conclusion the third party expert opinion is very often called upon when it comes to arbitrage, assessment or dispute and this why rating agencies have a place in the business society and are reference to the investment society. This does not prevent anybody to make his own due diligence and the outcome may well be that no one will have time, or the background to perform this work and no one will allocate his savings in any investment.

  14. SR commented on Apr 11

    Wally…your reference: “Enabler”

    So you are stating that one must perform dd w/in an unbaised setting. Great!

    Regarding the present status of performing dd w/unbiased ratings service providers (Moody/Finch/S&P) is comparable to the small town whereby the town’s mayor (also serving as sheriff) owns the only liquor store AND the rehab clinic (what a coincidence: next door to each other) would not be considered enabling…in your esteemed view?

    LMAO

  15. Marcus Aurelius commented on Apr 11

    They’re Ratings Agencies. If they can’t preform that function in a forthright and ethical way, why do they exist?

  16. DonKei commented on Apr 11

    Moody’s would still be a credible, viable company providing a valuable service to investors had it not succumbed to the siren song of growth.

    Why do companies think bigger is always better?

    Toyota is another company that has heard the siren song of growth as an end unto itself, and its quality has steadily declined. Being the biggest, or even just bigger than before, does not make a company better, and especially not if it causes a lost focus on how it succeeded in the first place.

    Moody’s is just another example of hubris and lost focus destroying a company’s reputation and its prospects. Sadly, there’s no shortage of similar examples these days.

  17. doc1 commented on Apr 11

    The Fed should allow the “free market” (ha ha ha) to judge the CRAs and what they’ve rated accordingly — but since the gov’t’s winking at the lack of transparency and the near complete lack of marking-to-market level 3 assets this has been in essence blocked. Sad…the rules seemingly keep changing nearly daily (FAS157??) and we’re all having to guess at how bad the financials really are. And how much we tax payers are on the hook.

    Instead the world is judging us accordingly.

    Ugh, we’re so screwed.

  18. Francois commented on Apr 11

    “On this on I must disagree with you. Any investor is responsible for his or her own due diligence. You cannot farm out the risk calculation for a fee.”

    Responsible for their due diligence…hmmm?

    That’s assuming it is possible to do so.

    What am I talking about?

    Check this blog entry from Yves Smith from Naked Capitalism talking about the problems in valuing CDO’s et al.:

    http://tinyurl.com/6yws9k

    The most surprising thing to me was:

    “And there are a few other barriers: you can’t get the deal documents. No kidding. The Fed can’t even get them because it isn’t a “qualified investor.” (Should the Fed start a hedge fund so it can study this problem?). From “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” by Joshua Rosner and Joseph Mason (pages 83-4):

    At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.

    So if regulators can’t get the description of the securities, market participants certainly won’t. So what good is a price if you aren’t really certain what is being traded?”

    The whole article is worth several reads. It shows that investors’ due diligence was just not possible.

    Mind you, this is the best reason I can think of to avoid this stuff in the first place.

  19. Francois commented on Apr 11

    “Instead of competition forcing the firm to be cautious in the face of other’s recklessness…”

    Competition? I was not aware that the rating agencies were competing against each other. Aren’t they an oligopoly protected by law?

    This whole adventure also clearly demonstrates that the concept of turning everything into a “profit center” is a failed one, to put it politely.

    Some endeavors must remain free of any other consideration than their primary focus. In other words, greed can obscure judgment in more ways then one.

    Sorry Mr. Gekko: Greed is not THAT good after all.

  20. Gari N. Corp commented on Apr 11

    So, can we bear all these comments in mind when asking why MBIA and CIFG, two rather wounded bond insurers, have decided that Moodys’ and S&P have much too much competition and have asked Fitch to stop rating them. Now you might argue that monolines, as something of a rating agency construct, have no business existing either, but they are both rather awkward reminder of how inefficient debt capital markets can be. everything that it happening on the ground points to the agencies cementing their position in securitization, much as happened in their utilities coverage after Enron collapsed (a situation in which they shouldered not a little blame).

  21. Unsympathetic commented on Apr 11

    All of the cartel should simply be forced to be paid only by the investors. The only approved ratings agency other than the 3 mentioned, Egan-Jones, has each of these bonds where they should be rated.

    Other institutions don’t like EJ, though, because EJ won’t play these games.

  22. A Reader commented on Apr 11

    Barry, good post except I think you are too hard on Buffett, where you say that he is the biggest investor in Moody’s. I have studied him closely, he’s unusual in that even when he takes a big stake, as he has in Moody’s, he is an unusually passive investor. I think your post implies that he exercises control, and that’s incorrect over Moody’s. He doesn’t use the influence that his shares give him. You have to watch him to realize just how unusually passive he really is as a shareholder, it is amazing. Moody’s has been a highly profitable investment for him, as you can see on page 15 the latest Berkshire Hathaway annual report. And Buffett is giving away virtually everything he earns on Berkshire to the Gates Foundation. So the reason his reputation hasn’t been hurt here, is that it doesn’t deserve to be.

    ~~~

    BR: Perhaps — I am not suggesting he is in any way at fault, but rather, that his rep might suffer

    Buffett is low key, and quite patient, but he has in the past made his unhappiness known to management. Besides, this is just the sort of junk that Buffett usually rails against . . .

  23. Darkness commented on Apr 11

    >On this on I must disagree with you. Any investor is responsible for his or her own due diligence. You cannot farm out the risk calculation for a fee. If Moody’s is to be held responsible, then they should have been given an equity holder position in things they rated, not given a fee.

    I’m having a hard time getting my brain around this libertarian logic. You want every single investor to research a semi-transparent/untransparent entity for viability. Even from Norway. Just the insurmountable inefficiency of that kills the reality of that idea. In fact, everyone who wants to buy a mutual bond fund better be spending several hours a day researching their positions. Brilliant plan that. That won’t create a drag on the economy at all. That’s like saying, we don’t need people to do auto safety reviews and crash tests, everyone who wants to buy a car should individually research it. Not only would it be a colossal waste of manhours but many organizations who want to participate in the market aren’t qualified to do the research. And if you restrict the market only the rare few who have time and are qualified… guess what? You don’t have a market anymore. Aye, the humanity.

    Secondly, making them an equity holder would have only made the situation worse. They have an inherently short-term mindset and going after the next quick buck by fudging more ratings would be the only way to cover for past bad ratings. I’ve got a better idea, make them buy “quality” insurance. When their ratings pan out over the long term (just like someone driving a car accident free for decades) they get a lower rate. If they start messing up ratings and the funds turn out sour, their insurance rates go up… until they are effectively priced out of participating in performing ratings at all.

  24. SR commented on Apr 11

    Slight of (accounting) Hand?

    No, the House always wins…

    Business Week

    Credit Crunch April 3, 2008, 5:00PM EST

    Death of a Bond Insurer

    Wall Street used ACA to hide loads of subprime risk. It worked—until the tiny company collapsed

    by David Henry and Matthew Goldstein

    Here’s another secret behind the mortgage mess: It turns out that Wall Street generally didn’t buy insurance on subprime bonds to protect against default. Instead, many big banks used the policies to play one set of accounting rules against another.

    The results of the game were bigger profits for banks, more money to continue cranking out securities built on risky subprime mortgages, and far less clarity about the banks’ true exposure to the toxic investments. The mess left by insurer ACA Financial Guaranty (ACAH), which collapsed in December, is now revealing just how critical the bond insurers’ role was in the mortgage market. In essence, ACA and the rest of the industry helped spur the boom to new heights, extending it far beyond its natural end point. cont…
    http://www.businessweek.com/magazine/content/08_15/b4079024463824.htm?campaign_id=rss_daily

  25. Alfred commented on Apr 11

    I think it is important to point out the short falls of the current system, and BR does a good job here. It is also important not to overemphasize the role of the rating agencies, regulators and investors in the current crisis because that takes away attention from the real problem. The originate-to-distribute model was designed to make term financial transaction infallible and replaced the old creditrisk-to-maturityrisk model. It did not withstand the test of the market place.
    A smarter man than I am, Paul Volcker, said in his keynote speech in NY: “The bright new financial system for all its talented participants and rich rewards has failed the test of the market place.”
    The question now is do we continue in this “victim mentality” and shift the blame or do we really want to solve the probelm?

  26. Ritchie commented on Apr 11

    Francois: “Should the Fed start a hedge fund so it can study this problem?”

    My view is that the entire Bush Administration is a hedge fund. Perhaps we need a way to put the costs of an administrations policies on its investors (voters).

  27. John commented on Apr 11

    I will be surprised if Moody’s is taken to task.

    A few weeks ago, Moody’s threatened to lower the US’s credit rating with the excuse that Social Security is financially out of control. Just previously, Congress was making threatening noises of investigating Moody’s wink-wink AAA credit ratings for worthless securities.

    I took Moody’s sudden interest in Social Security and the US’s credit rating to be a threat countering Congress’s interest in Moody’s dishonest ratings.

    Since then, I haven’t seen any further interest in Congress pursuing its investigation.

    I do think Moody’s should be taken to task for enabling toxic debt. And for threatening the US Government, I think its executive officers should be taken to the basement of the J. Edgar Hoover Building and shot.

    Neither is going to happen.

  28. ef commented on Apr 11

    The operative words, “used to be an ivory tower of finance”.

    Why keep talking about the rating agencies as if they are any different today than when they colluded with the same industries they were rating for profits and favors, at the detriment of investors who thought they could trust them. After all they were marketed as a version of a “watch dog” for the integrity of our financial systems. Their usefulness for the industry was “trust”, and they sold that a long time ago. Now they are simply an impediment, a symbol of the shoddy quality of our financial systems that we all depend on to live today and into our retirements.

    I wonder what impact this has had, Justice Department Increasingly Avoiding Corporate Prosecutions.

  29. farmera1 commented on Apr 12

    Comment on Buffett’s approach to buying stock (vs buying the entire company).

    Buffett has taken a hands off approach to companies where he holds stock and I’ll explain below why it has to be that way. A few years ago he had a large stock holding in Fannie Mae. He sold out, when asked why he didn’t try to change things rather than just sell, he said he would not get involved in a proxy fight so he sold his holdings. Subsequent results showed that there were indeed seious financial accounting problems at Fannie.

    I have no idea why he didn’t sell Moody’s, (Buffett is the rare leader that talks a lot about his mistakes and he has made several) but in the past he really hasn’t attempted to the best of my knowledge, to change a companies way of doing business as a stock holder.

    He certainly emphasizes trust when he buys an entire company, and largely leaves the CE0 in place and lets the companies run themselves with minimal interference. He (apparently) uses the same approach for owning stock.

    With 19 people in the corporate office and
    some 230,000 employees in 76 companies Berkshire Hathaway owns out right and some $75 billion in stock investments plus some $50 billion in cash, there is no way for him to do other wise IMHO. His time is best spent buying good companies (and stocks) and that is what he does. And yes he does make mistakes, but he does talk about his mistakes.

    (PS Berkshire Hathaway is the best low cost mutual fund in the world IMHO).

  30. Blissex commented on Apr 12

    «By the height of the mortgage-securities frenzy in 2006, Moody’s had pulled even with its largest competitor, rating nine out of every 10 dollars raised in these instruments. It gave many of the bonds its coveted triple-A rating.
    Profits at the 99-year-old firm, which John Moody started to rate railroad bonds, rose 375% in six years. The share price quintupled.
    Now, Moody’s and the other two major rating firms, the Standard & Poor’s unit of McGraw-Hill Cos. and the Fitch Ratings unit of Fimalac SA, are under fire for putting top ratings on securities that ultimately collapsed in value.»

    Well, to be a WINNER, you have to do whatever it takes — and Moody’s stupendous profit and stock price growth created many WINNERS. That’s how Wall Street works.

    «This whole adventure also clearly demonstrates that the concept of turning everything into a “profit center” is a failed one, to put it politely.»

    Failed? Moody’s stupendous profit and stock price growth created a lot of WINNERS. That looks like enormous success to me.

    Look also at how much money have Mozillo, ONeill, Rayne and other WINNERS have made thanks to Moody’s newfound incentives towards profit-oriented ratings.

    Those guys have had enormous productivity and have helped created a fabulous all-American boom. Moody’s should be thanked for enabling their just rewards.

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